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12 Inflation Chapter 12 INFLATION Chapter Key Ideas From Rome to Rio de Janeiro A. Inflation is a very old problem and some countries even in recent times have experienced rates as high as 40 percent per month. B. The United States has low inflation now, but during the 1970s the price level doubled. C. Why does inflation occur, how do our expectations of inflation influence the economy, is there a tradeoff between inflation and unemployment, and how does inflation affect the interest rate? Outline I. Inflation and the Price Level A. Inflation is a process in which the price level is rising and money is losing value. 1. Inflation is a rise in the price level, not in the price of a particular commodity. 2. Figure 12.1 illustrates the distinction between inflation and a one-time rise in the price level. 3. The inflation rate is the percentage change in the price level; that is, the inflation rate is [(P1 – P0)/P0] × 100 where P1 is the current price level and P0 is last year’s price level. 4. Inflation can result from either an increase in aggregate demand— demand-pull inflation—or a decrease in aggregate supply—cost- push inflation. 263 264 CHAPTER 12 II. Demand-Pull Inflation A. Demand-pull inflation is an inflation that results from an initial increase in aggregate demand. 1. Demand-pull inflation can result from any factor that increases aggregate demand. 2. Two factors controlled by the government are increases in the quantity of money and increases in government purchases. 3. A third possibility is an increase in exports. B. Initial Effect of an Increase in Aggregate Demand 1. Figure 12.2 illustrates the start of a demand-pull inflation 2. Starting from full employment, an increase in aggregate demand shifts the AD curve rightward. Real GDP increases, the price level rises, and an inflationary gap arises. 3. The rising price level is the first step in the demand-pull inflation. C. Money Wage Rate Response 1. The higher level of output means that real GDP exceeds potential GDP—an inflationary gap. 2. The money wage rate rises and the SAS curve shifts leftward. 3. Real GDP decreases back to potential GDP but the price level rises again. D. A Demand-Pull Inflation Process 1. Figure 12.3 illustrates a demand-pull inflation spiral. 2. Aggregate demand keeps increases and the process just described repeats indefinitely. 3. Although any of several factors can increase aggregate demand to start a demand-pull inflation, only an INFLATION 265 ongoing increase in the quantity of money can sustain it. 4. Demand-pull inflation occurred in the United States during the late 1960s and early 1970s. III. Cost-Push Inflation A. Cost-push inflation is an inflation that results from an initial increase in costs. There are two main sources of increased costs: an increase in the money wage rate or an increase in the money price of raw materials, such as oil. B. Initial Effect of a Decrease in Aggregate Supply 1. Figure 12.4 illustrates the start of cost-push inflation. 2. A rise in the price of oil decreases short-run aggregate supply and shifts the SAS curve leftward. Real GDP decreases and the price level rises—a combination called stagflation. 3. The rising price level is the start of the cost-push inflation. C. Aggregate Demand Response 1. The initial increase in costs creates a one-time rise in the price level, not inflation. To create inflation, aggregate demand must increase in response to the decrease in aggregate supply. 2. Figure 12.5 illustrates an aggregate demand response to stagflation, which might arise because the Fed stimulates demand to counter the higher unemployment rate and lower level of real GDP. 3. The increase in aggregate demand shifts the AD curve rightward. 4. Real GDP increases and the price level rises again. 266 CHAPTER 12 D. A Cost-Push Inflation Process 1. Figure 12.6 illustrates a cost-push inflation spiral. 2. If the initial decrease in aggregate supply was the result of oil producers raising the price of oil, what happens next depends on their response. If oil producers again raise the price of oil to try to keep its relative price higher, and the Fed responds with a further increase in aggregate demand, the process of cost-push inflation continues. 3. Cost-push inflation occurred in the United States during 1974–1978. IV. Effects of Inflation A. Unanticipated Inflation in the Labor Market 1. Unanticipated inflation has two main consequences in the labor market: it redistributes income and brings departures from full employment. 2. Higher than anticipated inflation lowers the real wage rate and employers gain at the expense of workers. Lower than anticipated inflation raises the real wage rate and workers gain at the expense of employers. 3. Higher than anticipated inflation lowers the real wage rate, increases the quantity of labor demanded, makes jobs easier to find, and lowers the unemployment rate. Lower than anticipated inflation raises the real wage rate, decreases the quantity of labor demanded, and increases the unemployment rate. 4. Unanticipated inflation imposes costs on both workers and firms. B. Unanticipated Inflation in the Market for Financial Capital 1. Unanticipated inflation has two main consequences in the market for financial capital: it redistributes income and results in too much or too little lending and borrowing. 2. If the inflation rate is unexpectedly high, borrowers gain but lenders lose. If the inflation rate is unexpectedly low, lenders gain but borrowers lose. 3. When the inflation rate is higher than anticipated, the real interest rate is lower than anticipated, and borrowers want to have borrowed more and lenders want to have loaned less. When the inflation rate is lower than anticipated, the real interest rate is higher than anticipated, and borrowers want to have borrowed less and lenders want to have loaned more. C. Forecasting Inflation 1. To minimize the costs of incorrectly anticipating inflation, people form rational expectations about the inflation rate. 2. A rational expectation is one based on all relevant information and is the most accurate forecast possible, although that does not mean it is always right. INFLATION 267 D. Anticipated Inflation 1. Figure 12.7 illustrates the effects of an anticipated inflation. 2. Aggregate demand increases, but the increase is anticipated, so its effect on the price level is anticipated. 3. The money wage rate rises in line with the anticipated rise in the price level. 4. The AD curve shifts rightward and the SAS curve shifts leftward so that the price level rises as anticipated and real GDP remains at potential GDP. E. Unanticipated Inflation 1. If aggregate demand increases by more than expected, inflation is higher than expected. The money wage rate does not adjust for all the inflation, and the SAS curve does not shift leftward enough to keep the economy at full employment. Real GDP exceeds potential GDP. The money wage rate eventually rises, which leads to a decrease in the SAS. The economy experiences more inflation as it returns to full employment. This inflation is like a demand-pull inflation. 2. If aggregate demand increases by less than expected, inflation is less than expected. The money wage rate rises too much and the SAS curve shifts leftward more than the AD curve shifts rightward. Real GDP is less than potential GDP. This inflation is like a cost-push inflation. F. The Costs of Anticipated Inflation 1. Anticipated inflation occurs at full employment with real GDP equal to potential GDP. 2. But anticipated inflation, particularly high anticipated inflation, inflicts three costs: a) Transactions costs. People spend money more rapidly when they anticipate high inflation and so transact more frequently, thereby incurring more transactions costs. b) Tax consequences. Anticipated inflation reduces the after-tax return from saving, which decreases capital accumulation and long-term economic growth. c) Increased uncertainty. A high inflation rate increases uncertainty, which makes long- term planning for investment more difficult and leads people to spend time forecasting inflation rather than undertaking more productive activities. Both of these effects reduce the economy’s long-term growth rate. V. Inflation and Unemployment: The Phillips Curve A. A Phillips curve is a curve that shows the relationship between the inflation rate and the unemployment rate. There are two time frames for Phillips curves. B. The Short-Run Phillips Curve 1. The short-run Phillips curve shows the relationship between inflation and unemployment holding constant the expected inflation rate and natural unemployment rate. 268 CHAPTER 12 2. Figure 12.8 illustrates a short-run Phillips curve (SRPC), which is a downward-sloping curve. 3. Figure 12.9 shows that the negative relationship between the inflation rate and unemployment rate is explained by the AS-AD model. An unexpectedly large increase in aggregate demand raises the inflation rate and increases real GDP, which lowers the unemployment rate. So higher inflation is associated with lower unemployment, as shown by a movement along a short-run Phillips curve. C. The Long-Run Phillips Curve 1. The long-run Phillips curve shows the relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate. 2. Figure 12.10 illustrates the long-run Phillips curve (LRPC), which is vertical at the natural unemployment rate. 3. Along the long-run Phillips curve, because a change in the inflation rate is anticipated, it has no effect on the unemployment rate. 4. Figure 12.10 also shows how the short-run Phillips curve shifts when the expected inflation rate changes. A lower expected inflation rate shifts INFLATION 269 the short-run Phillips curve downward by an amount equal to the decrease in the expected inflation rate.
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